Define working capital and explain the working capital cycle
Working capital is a measure of the business organizations ability to meets its short-term debts or obligations. All businesses must pay their day-to-day dues or bills in order to remain in operation. The consequences of not meeting payments when they are due are, for example; staff refusing to work, suppliers unwilling to provide raw materials or any number of supplies, or for that matter the electricity being turned off and eviction notices being issued for non-payment of rent. Consequently, an organization must be able to meet its day-to-day obligations in order to fulfill one of its main goals of survival and thereby remain in business.
Meeting day-to-day obligations involves the use of assets. Assets are the resources of a business used in the economic activity to generate goods or services. Assets that are capable of being used within the yearly day-to-day operation of business to generate economic activity are referred to as Current Assets. Liabilities are the obligations or debts that a business must meet. In other words if you owe somebody something, you have a liability. Current liabilities are those obligations that must be met within the yearly day-to-day conduct of business in order for the business to remain operational. Consequently, the ratio (numerical relationship) of Current Assets to Current Liabilities determines the Working Capital of a business organization. The determination of how much working capital a business organization has in its possession is through the following formula.
Current Assets – Current Liabilities = Working Capital
As previously stated, a business needs Working Capital in order to pay salaries to its workers, pay the cost of rent and other daily or monthly obligations. The inability of a business to meet these costs will mean that its ratio of Current Assets to Current Liabilities is out-weighed by the Current Liabilities. Therefore positive Working Capital is what remains when all Current Liabilities have been met.
The Working Capital Cycle shows the various intervals between payments and receipts. Throughout the production process the business must manage its working capital in order to ensure that business operations can continue smoothly. Businesses usually collect and make payments at different periods of time. In the very beginning of the production process credit is generally extended by suppliers to the business for raw materials. This credit facility usually runs from 30days to 90days. In other words, through an extension of credit a business will not be obligated to immediately meet the payment for goods collected until this time elapses.
By the same measure, when goods are sold to customers in the final phase of the production process, the business may in turn extend its own credit facility to its clients. Even during the production process itself, when partially finished goods and final goods are created time lags are created and need to be managed in order to ensure a healthy working capital cycle. It is simply a question of whether enough payments or receipts for goods produced and sold are enough to meet the costs or payments associated with productivity. These time lags may occur due to work-in-progress or even when the finished goods are completed pending sales. In this respect businesses seek to reduce the production cycle through lean production techniques or Just-In-Time production techniques. Managing the working capital cycle directly impacts the businesses ability to control costs, since these will affect liquidity and profitability.
Cash-flow forecasts Prepare a cash-flow forecast from given information
All businesses must manage their operations through control of the Working Capital cycle. When a company’s liquidity is referred to, this generally means the amount of minted coins and printed money (cash) in its possession. In this respect businesses must monitor the amount of cash they anticipate receiving and spending through what is referred to as Cash Flow Forecasting. This estimates all future Receipts (cash inflows) and Payments (cash outflows). The Cash Flow Statement, which we shall look at when examining Financial Statements, is not the same as Cash Flow Forecasts. The latter is a forward-looking planning tool while the former is a reporting method that includes Receipts and Payments from the past.
The Cash Flow Forecast will attempt to predict future receipts and payments based on historical trends. The forecast thereafter is a month-by-month estimation of cash flow.
Cash Flow Forecast
($000’s)
January
February
March
April
May
June
Receipts
Total receipts
Payments
Total Payments
Net cash Flow
Opening Balance
Closing Balance
Figure 5a.
To begin with as shown in figure 5a, the Cash Flow Forecast should be subdivided to reflect the number of months mentioned in the data that would be provided. The above sample is from January through June. Students must indicate the value of the cash being received, be it in thousands or millions.
The underlying format for the Cash Flow Forecast must include the following categories:
Receipts
Payments
Net Cash Flow
Opening Balance and
Closing Balance.
The challenge students will face will not be in the calculation of the Cash Flow Forecast but in determining how to place the data in the appropriate categories. Therefore, students will be expected to conceptually understand how to correctly identify which information should be included in each category.
Receipts: These are all inflows the business organization receives. Essentially, receipts are any positive contribution towards the cash position of the business. Therefore, revenue from ticket sales or any type of sale, loans from banks and collection of unpaid debts would fall under this category. The Total Receipts will be the accumulated value of the Receipts.
Payments: These are all the outflows from the business organization. Payments reduce the liquidity of the business but are a necessary element of operation. Most of the payments are expense items such as salaries, rent, electricity payments or loan repayments. The Total Payments will be the accumulated value of all the Payments.
Net Cash Flow: This is the difference between the Receipts and Payments and is calculated as follows: Total Receipts – Total payments = Net Cash Flow. The Net Cash Flow represents how much cash has been retained after all payments have been paid in the period.
Opening Balance: The Opening Balance is the value that has been carried forward from the prior period. This can be a positive of negative number. The Opening Balance is therefore the ongoing record of the cash position of the business.
Closing Balance: The difference between the Net Cash Flow and the Opening Balance is the Closing Balance calculated as follows: Sum of Net Cash Flow and Opening Balance = Closing Balance
In order to maintain an accurate record, this Closing Balance must be carried forward to the next period or next month.
Figure 5b below is a six-month Cash Flow forecast for a business January. Can you solve for the missing data?
Cash Flow Forecast
($000’s)
January
February
March
April
May
June
Receipts
Cash Sales
2,000
1,600
2,500
1,500
2,200
1,500
Total receipts
2,000
1,600
2,500
1,500
2,200
1,500
Payments
Rent
50
50
50
50
50
50
Salaries
20
20
20
20
20
20
Total Payments
(70)
(70)
(70)
(70)
(70)
(70)
Net cash Flow
1930
1530
?
?
?
?
Opening Balance
(955)
975
?
?
?
?
Closing Balance
975
?
?
?
?
?
Figure 5b.
Businesses plan Cash Flow Forecasts in order to avoid any financial shortcomings that might lead to insolvency, the inability to make payments. By carefully monitoring the cash flow support is given to strategic planning and the future prospects of the enterprise.
Evaluate strategies for dealing with liquidity problems
Businesses sometimes will misrepresent their Cash Flow Forecasts by overstating them. This means that they put a higher figure on Receipts than is realistically possible. Forecasts may also be understated whereby the Payments are said to be lower than the realistic figures indicate. In both scenarios that business would appear to have a positive cash flow. Therefore, if forecasts are willfully biased they may understate payments and overstate receipts. This practice of improperly reporting the position of the business is unethical and violates rules of conduct. However, because the forecast is in itself an estimate and is based on historical numbers, the inaccuracy stemming from this data can also be misleading.
In order to make sure that business organizations do not experience negative cash flows a business must have strategies in place when there is a liquidity crisis. This could include · the negotiation of short-term bridge loans
· offering discounts on products or services being sold
· requesting the extension of credit from suppliers or lenders beyond the usual repayment periods
· making adjustments to purchases and all other payments
· selling non-critical assets in order to raise the cash needed
When a business is faced with a liquidity crisis the objective is no longer profit maximization but rather survival. In order to have a tight control of the inflows and outflows of cash and not find itself in a liquidity crisis the essential tool a business organization must employ is a Budget.
Cash Flow Forecasts should not be confused with calculations for net cash flows. The former is a prediction of that includes all the aforementioned receipts, opening balances and closing balances. However, the net cash flow is a simpler calculation.
For example, assume that for the sale of bread its costs .50 Cents to manufacture and 1000 loaves are sold for $2 per year over a 5year period. In order to calculate the annual net cash flows for each year the following simpler formulation is applied in Figure 5c. .
Cash inflow
Cash outflow
Net cash flow
Year 1
(2 x 1000) 2000
(.5 x 1000) 500
(2000 - 500) 1,500
Year 2
(2 x 1000) 2000
(.5 x 1000) 500
(2000 – 500) 1,500
Year 3
(2 x 1000) 2000
(.5 x 1000) 500
(2000 – 500) 1,500
Year 4
(2 x 1000) 2000
(.5 x 1000) 500
(2000 – 500) 1,500
Year 5
(2 x 1000) 2000
(.5 x 1000) 500
(2000 – 500) 1,500
Net Cash Flow
$7,500
Figure 5c.
Reflection Point
When business is unable to pay its debts it faces a cash flow crisis.
Employees are the most valuable asset any company has, and without the ability to pay the workers, Business Organizations are left with some difficult decisions.
Being insolvent or unable to make your debt payments can lead to debtors making demands for payment through the legal system. If the debtors are successful all the firms assets could potentially be sold in order to meet the outstanding debt payments.
Working Capital Cycle
Define working capital and explain the working capital cycle
Working capital is a measure of the business organizations ability to meets its short-term debts or obligations. All businesses must pay their day-to-day dues or bills in order to remain in operation. The consequences of not meeting payments when they are due are, for example; staff refusing to work, suppliers unwilling to provide raw materials or any number of supplies, or for that matter the electricity being turned off and eviction notices being issued for non-payment of rent. Consequently, an organization must be able to meet its day-to-day obligations in order to fulfill one of its main goals of survival and thereby remain in business.
Meeting day-to-day obligations involves the use of assets. Assets are the resources of a business used in the economic activity to generate goods or services. Assets that are capable of being used within the yearly day-to-day operation of business to generate economic activity are referred to as Current Assets.
Liabilities are the obligations or debts that a business must meet. In other words if you owe somebody something, you have a liability. Current liabilities are those obligations that must be met within the yearly day-to-day conduct of business in order for the business to remain operational. Consequently, the ratio (numerical relationship) of Current Assets to Current Liabilities determines the Working Capital of a business organization. The determination of how much working capital a business organization has in its possession is through the following formula.
Current Assets – Current Liabilities = Working Capital
As previously stated, a business needs Working Capital in order to pay salaries to its workers, pay the cost of rent and other daily or monthly obligations. The inability of a business to meet these costs will mean that its ratio of Current Assets to Current Liabilities is out-weighed by the Current Liabilities. Therefore positive Working Capital is what remains when all Current Liabilities have been met.
The Working Capital Cycle shows the various intervals between payments and receipts. Throughout the production process the business must manage its working capital in order to ensure that business operations can continue smoothly. Businesses usually collect and make payments at different periods of time. In the very beginning of the production process credit is generally extended by suppliers to the business for raw materials. This credit facility usually runs from 30days to 90days. In other words, through an extension of credit a business will not be obligated to immediately meet the payment for goods collected until this time elapses.
By the same measure, when goods are sold to customers in the final phase of the production process, the business may in turn extend its own credit facility to its clients. Even during the production process itself, when partially finished goods and final goods are created time lags are created and need to be managed in order to ensure a healthy working capital cycle. It is simply a question of whether enough payments or receipts for goods produced and sold are enough to meet the costs or payments associated with productivity. These time lags may occur due to work-in-progress or even when the finished goods are completed pending sales. In this respect businesses seek to reduce the production cycle through lean production techniques or Just-In-Time production techniques. Managing the working capital cycle directly impacts the businesses ability to control costs, since these will affect liquidity and profitability.
Cash-flow forecasts
Prepare a cash-flow forecast from given information
All businesses must manage their operations through control of the Working Capital cycle. When a company’s liquidity is referred to, this generally means the amount of minted coins and printed money (cash) in its possession. In this respect businesses must monitor the amount of cash they anticipate receiving and spending through what is referred to as Cash Flow Forecasting. This estimates all future Receipts (cash inflows) and Payments (cash outflows). The Cash Flow Statement, which we shall look at when examining Financial Statements, is not the same as Cash Flow Forecasts. The latter is a forward-looking planning tool while the former is a reporting method that includes Receipts and Payments from the past.
The Cash Flow Forecast will attempt to predict future receipts and payments based on historical trends. The forecast thereafter is a month-by-month estimation of cash flow.
To begin with as shown in figure 5a, the Cash Flow Forecast should be subdivided to reflect the number of months mentioned in the data that would be provided. The above sample is from January through June. Students must indicate the value of the cash being received, be it in thousands or millions.
The underlying format for the Cash Flow Forecast must include the following categories:
The challenge students will face will not be in the calculation of the Cash Flow Forecast but in determining how to place the data in the appropriate categories. Therefore, students will be expected to conceptually understand how to correctly identify which information should be included in each category.
In order to maintain an accurate record, this Closing Balance must be carried forward to the next period or next month.
Figure 5b below is a six-month Cash Flow forecast for a business January. Can you solve for the missing data?
Businesses plan Cash Flow Forecasts in order to avoid any financial shortcomings that might lead to insolvency, the inability to make payments. By carefully monitoring the cash flow support is given to strategic planning and the future prospects of the enterprise.
Evaluate strategies for dealing with liquidity problems
Businesses sometimes will misrepresent their Cash Flow Forecasts by overstating them. This means that they put a higher figure on Receipts than is realistically possible. Forecasts may also be understated whereby the Payments are said to be lower than the realistic figures indicate. In both scenarios that business would appear to have a positive cash flow. Therefore, if forecasts are willfully biased they may understate payments and overstate receipts. This practice of improperly reporting the position of the business is unethical and violates rules of conduct. However, because the forecast is in itself an estimate and is based on historical numbers, the inaccuracy stemming from this data can also be misleading.
In order to make sure that business organizations do not experience negative cash flows a business must have strategies in place when there is a liquidity crisis. This could include
· the negotiation of short-term bridge loans
· offering discounts on products or services being sold
· requesting the extension of credit from suppliers or lenders beyond the usual repayment periods
· making adjustments to purchases and all other payments
· selling non-critical assets in order to raise the cash needed
When a business is faced with a liquidity crisis the objective is no longer profit maximization but rather survival. In order to have a tight control of the inflows and outflows of cash and not find itself in a liquidity crisis the essential tool a business organization must employ is a Budget.
Cash Flow Forecasts should not be confused with calculations for net cash flows. The former is a prediction of that includes all the aforementioned receipts, opening balances and closing balances. However, the net cash flow is a simpler calculation.
For example, assume that for the sale of bread its costs .50 Cents to manufacture and 1000 loaves are sold for $2 per year over a 5year period. In order to calculate the annual net cash flows for each year the following simpler formulation is applied in Figure 5c.
.
When business is unable to pay its debts it faces a cash flow crisis.
Employees are the most valuable asset any company has, and without the ability to pay the workers, Business Organizations are left with some difficult decisions.
Being insolvent or unable to make your debt payments can lead to debtors making demands for payment through the legal system. If the debtors are successful all the firms assets could potentially be sold in order to meet the outstanding debt payments.
Complete the Insolvency and Bankruptcy activity and submit all the exercises involved in the tasks.
Suggest two ways in which your school could improve cashflow.